Meanwhile, new
Basel rules on the risk-based capital regime, including the
standardized and advanced approach, challenge the profitability
of bank lending given higher equity requirements, while
penalizing foreign-currency exposures, among other things.

As a result, banks more than ever are paying attention
– both from an operational and regulatory risk
perspective – to how they set intra-day credit
exposures to their counterparties.

A bilateral credit model is where two parties extend credit
to each other for trades, whereas under central credit or
central clearing a third party interposes itself between the
two counterparties, becoming the buyer to every seller and the
seller to every buyer. A debate is now brewing about the
relative appeal of both models.

Jon Vollemaere,
R5

Proponents of central credit such as Jon Vollemaere, CEO of
R5, says the central credit model improves credit efficiency,
provides wider access to new participants and enables banks to
trade with an expanded group of counterparties via their prime
broker while also reducing the number of credit lines that have
to be maintained.

"Banks are already reviewing their trading relationships,"
says Vollemaere. "In the past, we saw an 'arms race' where the
big banks were flow monsters – we don’t
see that any more. As credit becomes more costly there will be
a continued focus on key accounts, as opposed to chasing the
whole market.

"If you have to collateralize every bilateral credit
relationship, a CCP model makes more sense in terms of cost.
Whilst most banks already have accounts with each other,
collateralization will mean changes in terms of minimums and
margin calls."

R5 uses a centralized credit model on its InterBank
platform. Vollemaere observes that the requirement for
bilateral credit relationships when trading emerging-market
currencies means the market is limited to a relatively small
universe of counterparties.

The over-the-counter (OTC) market has operated using bilateral
credit for a long time, but it has always been difficult to
allocate a precise cost to that credit, he says, adding: "Now
the industry [given increased regulatory scrutiny] will be
forced into better understanding its costs relative to its
risk."

Bilateral belief

This is not to say that bilateral relationships are doomed.
As James Sinclair, CEO of fintech firm MarketFactory, observes
there will be customers – especially those who are
hedging rather than seeking alpha from FX – who want a
broad cross-product, full-service relationship with just a few
banks.

Also, the headline cost of clearing can be higher than that
derived from bilateral relationships. Most clearing houses
insure against both settlement risk and market risk in case a
counterpart fails, whereas many participants accept insurance
of only the settlement risk and effectively self-insure market
risk.

In addition, credit intermediation is not exempt from global
trends.

"The world is becoming more peer-to-peer, unbundled and
networked," says Sinclair. "It has affected execution
– witness how the market first consolidated around two
major ECNs but then fragmented. It is affecting consumer
lending and, though we don't yet know how, will surely affect
credit intermediation."

"Beyond tier-1 banks, many market participants are being forced
away from their prime brokerage relationship and more into
bilateral credit arrangements," he says. "Prime-of-prime
brokerage firms [which provide leverage alongside the largest
prime brokerage units often to small and mid-sized clients] may
have stepped in to fill this void, but it will take time for
this model to fully settle in."

However, once this is achieved, Baggioli says the market
will return to favouring a central credit model.

According to Dmitri Galinov, CEO of FastMatch, an FX ECN,
this would create one significant clearing exchange beneficiary
since the market will not tolerate multiple clearing exchanges
with non-fungible instruments.

"Such exchange would also benefit from increased trading
volumes due to cross-margining of the OTC FX versus the
products traded on the exchange," says Galinov. "A good central
clearing solution would increase liquidity since it would bring
more players to the market and decrease margin requirements and
the cost of post-trade processing."

Bryan Seegers,
ADS Securities

While the group of institutions that no longer have direct
access to a tier-1 institution might not have direct access to
the diversity of liquidity they once did, there is still a
sufficient number of organizations with significant credit
lines and reach that will act as intermediaries on a
prime-of-prime basis, adds Bryan Seegers, director of eFX
pricing & execution at ADS Securities Abu Dhabi.

"The liquidity is still there, although costs are likely to
increase," he concludes. "Further to this, many ECNs are
enticing people to use their venues for disclosed direct
relationships, further allowing people access to the liquidity
they need – although counterparties are then obliged
to use the ECN’s pricing."

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